What Happens to My Tax Refund in a Chapter 7 Bankruptcy?

Posted on Mar 22, 2012 11:19pm PDT

Holding on to your 2011 IRS and California tax refunds when you're filing a Chapter 7 bankruptcy is a matter of careful timing and tactics. In most cases we can help you keep your refunds, but we have to work closely together to make that happen.

Be aware that when your Chapter 7 bankruptcy is filed, everything you own becomes your "bankruptcy estate." The vast majority of the time everything in that "estate" is "exempt," meaning that it is protected. Your bankruptcy trustee and your creditors are prevented from taking anything from you that is exempt, which usually includes everything that you own.

When your bankruptcy is filed, that "bankruptcy estate" includes not only possessions that you would normally think of as your "assets"-things that you can see and touch. It also includes intangible assets, including money owed to you but not yet paid. So if your Chapter 7 case is filed at the point in time when you are owed a tax refund, that refund is an intangible asset of your "estate," and subject to being claimed by the trustee.

But what if you have not yet even prepared your tax return and have no idea how much your tax refund will be, or even if you'll be entitled to one at all? How can that possible refund be an asset and then part of your bankruptcy estate before anyone even knows whether it will amount to anything?

To make better sense of this, understand that your income tax refunds usually consist of money returned to you for overpaying payroll withholdings made by your employer to the IRS and/or the California Tax Franchise Board during the course of the tax year. So, right after your last paycheck of the year is processed and the last withholding taken from your salary or wages, you have made your last overpayment related to that year's refund. As a result, even though nobody knows the amount of your refund until your tax return is prepared a few weeks or months later, for bankruptcy purposes you've already overpaid your taxes and have a right to that overpayment-a right to your tax refunds--as of January 1 of the new year. The fact that you don't yet know the amount that you have a right to, or don't know for sure that you have a right to a refund this year, does not change that you do in fact have a right to a refund (if in fact one turns out to be owed to you). What you know or expect about a refund is irrelevant to the existence of your right to the refund.

So, if your Chapter 7 case is filed after December 31 but before you have received and spent your 2011 tax refund, that refund belongs to your "bankruptcy estate" and is subject to be taken from you by the trustee. To be clear, this is also true if you have received the refund but still have the check itself or the money from the refund check when your case is filed.

You can prevent your tax refunds from belonging to your bankruptcy estate by filing your tax returns, AND receiving and appropriately spending the refunds, BEFORE your Chapter 7 case is filed. But doing this without very specific advice from your attorney is very dangerous. The trustee is very interested in any money you receive and what you spend it on before filing bankruptcy. You can very easily spend the refunds in ways that seems perfectly sensible but then cause major problems.

But what if you have to file your bankruptcy quickly and can't wait until your tax refunds are received and appropriately spent? Referring back to the first paragraph of this blog, even if your bankruptcy is filed so that the refund is an asset of your "estate," you may still keep part or all of your refunds if they are "exempt"-protected.

Describing and applying the California exemption scheme to this situation would take a whole separate blog (or two!). It is also an area in which you definitely should get advice from an experienced bankruptcy attorney.

The bottom line: if you can, time the filing of your bankruptcy case so that your tax refunds are not assets of your bankruptcy estate. And if you can't, try to fit the refund into an available exemption so that you can keep all or at least part of your refunds.

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